AgPa #59: Why and When Institutional Investors Fire Asset Managers

Forbearance in Institutional Investment Management: Evidence from Survey Data (2023)
Amit Goyal, Ramon Tol, Sunil Wahal
Financial Analysts Journal 79(2), 7-20, URL

This week’s AGNOSTIC Paper comes from a project that I am currently doing in my day job. As I mentioned sometimes, I am working as a portfolio manager at a life insurance company. Like most institutional investors, we don’t do everything ourselves and work with external asset managers for a variety of strategies. A meaningful part of my job therefore involves launching, monitoring, and sometimes also terminating mandates with asset managers.

As we all know, extracting excess returns from (equity) markets is not so easy. Identifying and monitoring managers who can reliably do that is therefore at least as difficult, if not harder. In particular, deciding whether to continue working with a temporary underperforming manager is often difficult. This week‘s paper examines how institutional reports approach this problem in practice…

Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.

Setup and Idea

Somewhat unconventionally, this week’s paper starts at the end of the manager selection process. At least from my experience, investors typically spend a lot of time preparing their investments and searching for the best-possible manager. This is of course important, but given that we operate in dynamic markets, continuous monitoring of asset managers and adjustments to the portfolio are at least as relevant (and sometimes neglected). At some point, investors must also decide if they want to continue with a manager or look for a better alternative.

Unsurprisingly, investors typically don’t think about firing a manager when things are going well. Such issues mostly arise during periods of bad performance. But there is a trade-off. In competitive financial markets, it is unrealistic to assume that an asset manager can outperform every quarter or year.1Of course, unless you invest with the few most elite hedge funds. But those usually don’t take your money… Exiting too fast could therefore be harmful and prevent you from getting the long-term benefits of the respective strategy. In addition to that, changing asset managers is quite some work and costly. On the other hand, sticking with something that deteriorates for good reasons also harms long-term performance and solving such a problem quickly would be the better choice. In practice, the challenge thus becomes to separate the two situations and decide accordingly.

Although this week’s paper doesn’t provide a specific answer to this challenge, it sheds some light on how institutional investors approach it. From my perspective, this is quite interesting and helps to create a custom process to approach this issue.

Data and Methodology

The relations between institutional investors and asset managers are typically private and there is no database which contains information about terminations of mandates. The authors therefore conduct a survey among employees of large institutional investors. Of course, the issue with surveys is that there may be differences between what people tell you they do and what they actually do. The authors are well-aware of this and try to mitigate this problem with various control questions and the setup of the survey.

The questions explicitly focus on reasons for terminating the relations with asset managers and the corresponding holding periods. The authors conduct their survey in cooperation with Institutional Investor, a leading publisher in the field. They sent their questionnaire to 6,135 institutional investors and received 218 responses from investors that collectively managed about $4.1T by July 2021. This is of course a relatively small sample. However, $4.1T is still a meaningful number and the survey captures a lot of different institutional investors which makes it somehow representative. For example, the 218 respondents stretch across 22 countries and cover 11 different types of organizations. The authors collapse those categories into four groups (Endowments and Foundations, Financial Institutions, Private Funds, Public Funds) and three geographies (Europe, North America, Rest of the World). The following table summarizes the sample and provides some information about the size and asset allocation of the responding institutions.

Table 1 of Goyal et al. (2023).

Important Results and Takeaways

Institutional investors are more patient than thought

Institutional investors and the asset management industry are sometimes accused of being overly obsessed with short-term performance. In addition to that, some also criticize that investment professionals occasionally take action just to show that they have done something.2Warren Buffett famously labelled such behavior the institutional imperative in his 1990 Shareholder Letter. The authors take on these arguments and report that about 70% of their respondents review their asset managers at least quarterly, and 90% at least annually. But as the holding periods in the following table show, this doesn’t necessarily translate into frequent actions. In addition to that, I agree with the authors that frequent reviews are part of institutional investors‘ fiduciary duty and not necessarily a sign of short-term thinking.

Table 2 of Goyal et al. (2023).

If anything, the reported holding periods are surprisingly long. For example, just 2.5% of the institutions reported holding periods of less than 3 years for equity mandates. In fact, the majority of respondents falls within the two longest holding period categories for all of the three asset classes. For Hedge Funds, however, investors seem to be bit less patient and willing to exchange managers faster.

Figure 2 of Goyal et al. (2023).

The authors further show reported holding periods by the type of institution and geography. While there are some differences, the pattern appears very robust. Most institutional investors report holding periods of more than 5 years for Equity and Fixed Income. With respect to the type of investor, Financial Institutions appear to be the most impatient but it is not clear if those differences are statistically significant. Another noteworthy result are the longer holding periods of North American investors. The authors explain that this result is somewhat unexpected because this region is often assumed to be more dynamic than Europe and the Rest of the World.

Although I find the results very interesting and appreciate the authors’ effort to conduct this survey, I think there are two important limitations to remember. First, those are “just” 218 of thousands of institutional investors out there. Second and probably more important, it remains a survey. The results are based on what investors say they are doing and we simply don’t know what they actually do. I have no direct empirical evidence to support it, but I could imagine that especially when it comes to patience, some investors rather report the situation they would like to have instead of the one they actually have.3Everyone wants to be patient and disciplined, I think this is just human. If you ask me how often I exercise per week, my answer is four times although some weeks look drastically different… But I don’t want to be overly skeptical and I generally find the results very useful.

Tolerance for underperformance is surprisingly long

The longer-than-expected holding periods already suggest that investors do not fire asset managers that often and are more tolerant to problems than some might have expected. The authors continue their analysis by asking investors for their main reasons to terminate the relation with an asset manager. They also ask how long they are willing to tolerate underperformance across the three asset classes.

Tables 3 and 4 of Goyal et al. (2023).

Performance-related issues are the most important reason for firing an asset manager within all three asset classes. It is not in the table, but the authors also mention that the differences between Performance-related issues and the other two reasons are statistically significant. I think this is not too surprising. In the end, investors need returns to meet their objectives and if a manager cannot deliver them the relation has to be terminated at some point.

The second-most important reason are Risk-related issues. I think that is quite interesting because it is again a trade-off. The authors explain that investors fire asset managers for both excessive and insufficient risk-taking. Intuitively, you don’t want someone who could ruin your portfolio but you also don’t want to pay an expensive manager for doing nothing different than a passive index fund.

The remaining Organizational-related issues capture all remaining reasons. Most importantly, these are allocation changes from the institutional investor itself and organizational changes at the manager. The first one probably doesn’t provide too much insights because if there is a decision to divest US equities, you must fire your manager even though she might do an outstanding job. The second one, however, is very important because if your manager deviates from what you have mandated her for, that is certainly a valid reason to terminate the relationship.

While performance is the most important factor, all three categories are fairly close to each other. The same is also true for the reasons across the three asset classes. To me, the results therefore suggest that investors evaluate managers quite holistically with an understandable focus on performance. I think these results are also interesting for asset managers to better understand the need of their clients.

It is again surprising how patient investors apparently are with respect to tolerating underperformance. The right-hand table above shows that the majority of respondents (66.2% and 56.6%, respectively) reported to tolerate underperformance for more than 3 years within Equity and Fixed Income. Investors seem to be again somewhat less patient for Hedge Funds, but generally those are very interesting results. That said, what is missing from my perspective is the magnitude of underperformance. Of course, it is very hard to get data on private investment records or ask such things in a survey. But I am quite confident that managers who underperform massively are fired much faster than suggested by these results.

Figure 4 of Goyal et al. (2023).

The authors again examine the reported tolerance for underperformance by the type of institution and geography. The results are very similar to the overall holding periods. Financial Institutions seem to be the most impatient investors with the highest share of respondents who tolerate underperformance for less than 3 years. On the contrary, Endowments appear to be the most forgiving in all of the three asset classes. With respect to geographies, the authors again find the same pattern as before. Against some prejudices, North American investors report themselves to be more tolerant and patient than Europe and the Rest of the World.

Sophistication and risk-appetite of investors do matter

In a separate analysis, the authors perform a Logit regression to explain the tolerance for underperformance by certain characteristics of investors. There are a few interesting relations but given the small sample and the potential issues from survey-data, I would personally regard them as rather indicative.

Most interestingly, the authors find that investors who use sophisticated multi-factor benchmarks are less tolerant for underperformance and tend to fire managers quicker. I think this is intuitive because if you better understand what your manager is doing and how it compares to an appropriate benchmark you have a clearer view if she adds value. The authors also find that within Equity and Fixed Income, investors who are willing to bear more tracking error risk also tend to be more tolerant for underperformance. This is logically consistent because if you want your managers to take more active risk, you should be able to stomach temporary underperformance.4A sarcastic note on this: It is not so obvious that the authors find a logically consistent result. In my experience, many people in the industry want to have the rewards of high risks without taking the downside…

Conclusions and Further Ideas

Deciding if and when to abandon an investment or firing an asset manager (the two are essentially the same) is not easy. Given the amount of random noise that can temporarily overrule even the best investment process, some tolerance for underperformance is absolutely necessary for long-term success. On the other hand, too much tolerance risks sticking to a broken process and can actually harm long-term success. In practice, the challenge therefore becomes to decide if it is random noise or if there is indeed something no longer working. This is the challenge of being an active investor and the paper doesn’t help here.

What the paper does provide, however, is an overview how some of the world’s institutional investors approach this challenge. And I think the overall direction of the results is quite clear. Given the longer-than-expected holding and tolerance periods, the institutions in this sample probably err on the side of sticking too long with something underperforming. Of course, the decision ultimately also depends on the time horizon. There is a lot of empirical evidence that Momentum dominates over shorter horizons while contrarian strategies like Value tend to outperform over longer horizons. Depending on where you are on this spectrum and what you believe in, the decision about an underperforming manager can look very different.

Although I am just working in the industry for 2.5 years and have only seen one institutional investor so far, the results are surprisingly consistent with what I have experienced. I also believe, and this is really just my personal opinion, that there are some pronounced psychological effects that support the long tolerance periods.

First, terminating and replacing an asset manager is quite some effort and costly. Second, firing an asset manager could be an uncomfortable situation and requires making oneself unpopular. Third and probably most important, you typically fire a manager after bad performance and this requires some form of loss realization. And as psychology shows, humans are not good in realizing losses and admit to themselves that they have been wrong on something.

In fact, such psychological biases can be even more relevant for asset manager selection than for investments in securities. I mean, investing in stocks is sufficiently difficult for itself. But a stock can at least not talk to you in a charming way and invite you for dinner to further impact your decision-making. Asset managers can (and usually will) do that… My personal takeaway from this paper is therefore that sticking with an asset manager through bad times is good, but you should have a clear reason why this is the right decision and not assume that problems just take care of themselves.

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1 Of course, unless you invest with the few most elite hedge funds. But those usually don’t take your money…
2 Warren Buffett famously labelled such behavior the institutional imperative in his 1990 Shareholder Letter.
3 Everyone wants to be patient and disciplined, I think this is just human. If you ask me how often I exercise per week, my answer is four times although some weeks look drastically different…
4 A sarcastic note on this: It is not so obvious that the authors find a logically consistent result. In my experience, many people in the industry want to have the rewards of high risks without taking the downside…